The private equity industry, learning to adapt

Learning to adapt

For much of the past decade, private equity has gone from strength to strength. Returns have continued to outperform many other alternative investment classes, but the good times are unlikely to keep rolling forever. If the industry enters a more challenging period as anticipated, fund managers may need to adapt.

Geopolitical and economic uncertainty has contributed to the private equity (PE) industry expecting the number of completed deals to drop this coming year. In addition, as the number of firms and PE players has shot up, so has the competition for deals, increasing deal prices and making it harder to find value.

For some, carving out a sector niche, focusing on education or financial services deals for example, provides important differentiation. Middle market managers have moved down market for a number of years, seeking underserved lower middle market companies, looking for the ‘diamond in the rough’ or perhaps information asymmetry to be leveraged. Not only has the industry become more exclusive, but if interest rates rise as expected, pressure on leverage levels will increase.

Good investor relations come easily when the returns are flowing. However, should current market dynamics lead to a period of relative tightening, communication and transparency will take on renewed importance. Seeing overpricing squeeze returns will make it more crucial than ever for managers to clearly, regularly and efficiently provide information on portfolio performance and strategy. Increasing reporting and assessments will become key for GPs (or LPs) looking to convey, articulate or efficiently analyze more portfolio data at the underlying level.

Smart firms are likely to take a proactive approach to costs. Increased pressure to avoid unnecessary expenses may lead some to take a second look at the accounting procedures of a firm and its funds. Given the availability of outsourced cost-saving solutions, managers should be engaging with back office specialists, as this would allow them to increase focus on what they do best – making deals and managing portfolios.

In fact, boom times or not, investors are always encouraged by greater transparency and frugality from GPs. It might have been easy to dismiss these concerns as trivial in the past, but they are increasingly a critical differentiator.

All industries ebb and flow. Although PE will likely continue to outperform other asset classes, GPs must remain vigilant. Even the possibility of a PE lull encourages action. The streamlining of fund costs and investor relations will not address all challenges, but it’s a good place to start. To do nothing, and rely on outdated methods that have worked previously, risks deterring LP interest. Many firms will continue in the same vein as before, but to remain ahead of the curve, forward thinking institutions will embrace the efficiencies to be gained by outsourcing to the right specialist.

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